Central Bank Credibility Research Articles

Imperfect Credibility versus No Credibility of Optimal Monetary Policy

Une crédibilité minimale de la banque centrale, avec une probabilité non nulle de ne pas revenir sur son engagement, est une condition nécessaire pour ancrer les anticipations d’inflation et garantir le retour de l’inflation vers sa cible de long terme. En revanche, l’absence complète de crédibilité, avec la certitude que la banque centrale reviendra sur son engagement (« discrétion optimale »), implique une bifurcation de la dynamique de l’inflation vers des trajectoires déflationnistes ou hyperinflationnistes. Dans l’exemple de la courbe de Phillips des nouveaux keynésiens, la politique optimale à très faible crédibilité impose une réponse de l’instrument de politique monétaire aux écarts de l’inflation de signe opposé à la politique de discrétion optimale, ce qui explique cette bifurcation.

The Excess Sensitivity of Long-term Interest rates and Central Bank Credibility

English Abstract: Long-term interest rates show considerable reactions to macroeconomic and monetary policy news. It is, however, difficult to be explained by standard rational expectations macro-finance models widely used in policy analyses. In this research, we demonstrate that private’s subjective beliefs and central bank credibility can account for the excess sensitivity of long-term interest rates using an estimated macro-finance model which incorporates private’s subjective perceptions on future real activity and inflation and endogenously evolving central bank credibility. We find that long-term rates respond stronger to macro shocks and shifts in private's perceptions regarding expected real activity and inflation when credibility is lower. In addition, the model simulation shows that 10-year yield varies substantially more when credibility is low.

Determinants of Price Rigidity and Flexibility: Some Survey Evidence for the Pakistan.

The objective of the study is to estimate the determinants of price stickiness or flexibility. Data is collected through structured questionnaire from 342 firms, which are selected through stratified random sampling technique from the Industrial Estate of Khyber Pakhtunkhwa. To estimate the determinants of price flexibility/rigidity, models are estimated through ordinary least squares technique and binary logistic technique. The most important factors for price stickiness are implicit/explicit price contracts and minimum price volatility. Imperfect competitive market structure, number of regular customers, backward-looking behavior, and credibility of central bank and size of the firm are important determinants of price rigidity. While economic literacy and information set regarding expected inflation make the prices flexible. Study recommend that monetary policy of Pakistan should use other transmission channels of money supply instead of traditional channel, because it is found that the degree of price rigidity is low in Pakistan. Keywords: Price Rigidity, Price Flexibility, Price Contract, Frequency of Price Change.

The communication effects on inflation forecast errors: Empirical evidence from Colombia

The purpose of this article is to explore the central bank?s ability to management inflation forecast errors in Colombia. We present empirical evidence based on the Colombian experience with data from the period of 2008 to 2020. The communication channel selected for analysis is the press releases. The empirical evidence is divided into three steps: (i) regression analysis using an EGARCH model; (ii) use of VAR models; and (iii) variance decomposition analysis. The communications effects are significant for several months and that close to half of the forecast error variance can be explained by innovations in central bank communication. The results obtained allow monetary policymakers to develop more efficient strategies for anchoring expectations and strengthening the central bank credibility.

Presidential antagonism and central bank credibility

AbstractThis paper uses an online survey experiment to study how President Trump's criticism of the Federal Reserve may affect consumers' long‐run inflation expectations, confidence in the Fed, and responsiveness to information about inflation. A random subset of respondents view one of President Trump's critical tweets about the Fed, or the tweet plus aWashington Postarticle discussing the President as a threat to the Fed's independence. All respondents provide long‐run inflation forecasts, before and after receiving information about past inflation and the Fed's inflation target. Finally, respondents rate their confidence in the President and the Fed. Respondents who view the tweet or tweet plus article have final long‐run inflation forecasts that are farther from the Fed's target after exposure to information about the Fed's target and recent inflation. Exposure to the tweet plus news article has a polarizing effect on confidence, increasing the share of respondents with high confidence in either the Fed or the President.

Coordinating expectations through central bank projections

Central banks are increasingly communicating their economic outlook in an effort to manage the public and financial market participants’ expectations. We provide original causal evidence that the information communicated and the assumptions underlying a central bank’s projection can matter for expectation formation and aggregate stability. Using a between-subject design, we systematically vary the central bank’s projected forecasts in an experimental macroeconomy where subjects are incentivized to forecast the output gap and inflation. Without projections, subjects exhibit a wide range of heuristics, with the modal heuristic involving a significant backward-looking component. Ex-Ante Rational dual projections of the output gap and inflation significantly reduce the number of subjects’ using backward-looking heuristics and nudge expectations in the direction of the rational expectations equilibrium. Ex-Ante Rational interest rate projections are cognitively challenging to employ and have limited effects on the distribution of heuristics. Adaptive dual projections generate unintended inflation volatility by inducing boundedly-rational forecasters to employ the projection and model-consistent forecasters to utilize the projection as a proxy for aggregate expectations. All projections reduce output gap disagreement but increase inflation disagreement. Central bank credibility is significantly diminished when the central bank makes larger forecast errors when communicating a relatively more complex projection. Our findings suggest that inflation-targeting central banks should strategically ignore agents’ irrationalities when constructing their projections and communicate easy-to-process information.

The Monetary Policy Credibility Channel and the Amplification Effects in a Semi-structural Model

The paper extends a standard semi-structural model to account for nonlinear and asymmetric effects of monetary policy credibility. In our setting, central bank credibility is proportional to the deviation of inflation expectations from the announced inflation target, with positive deviations being more costly compared to negative ones. A loss in policy credibility as a result of shocks leads to a more persistent, backward-looking inflation process, and is associated with lower output. We find that the extended model with credibility effects matches well the key macroeconomic data over specific past episodes for Indonesia and Philippines and consider its adaptation to integrated policy frameworks as an area for further exploration.

Forward guidance and the role of central bank credibility under heterogeneous beliefs

This paper studies the macroeconomic effects of central bank forward guidance when central bank credibility is endogenous. We take a stylized New Keynesian model with an occasionally binding effective lower bound constraint on nominal interest rates and heterogeneous and boundedly rational households. Central bank forecasts follow a bivariate VAR, not taking into account the time-variation in the distribution of aggregate expectations. In this framework, we extend the central bank’s toolkit to allow for the publication of its own forecasts (Delphic guidance) and the commitment to a future path of the nominal interest rate (Odyssean guidance). We find that both Delphic and Odyssean forward guidance increase the likelihood of recovery from a liquidity trap. Even though Odyssean guidance alone appears more powerful in inducing recovery, we find it to increase ex post macroeconomic volatility and thus reduce welfare.

The Effect of Central Bank Credibility on Forward Guidance in an Estimated New Keynesian Model

This paper examines the effectiveness of forward guidance in an estimated New Keynesian model with imperfect central bank credibility. We estimate credibility for the U.S. Federal Reserve with Bayesian methods exploiting survey data on interest rate expectations from the Survey of Professional Forecasters (SPF). The results provide important takeaways: (1) The estimate of Federal Reserve credibility in terms of forward guidance announcements is relatively high, which indicates muted forward guidance effectiveness relative to the fully credible case. Hence, anticipation effects are attenuated and, accordingly, output and inflation do not respond as favorably to forward guidance announcements. (2) The so-called “forward guidance puzzle” is shown to arise, at least in part, from the unrealistically large responses of macroeconomic variables to forward guidance statements in structural models that do not incorporate imperfect credibility and heterogeneous expectations. (3) Imperfect monetary authority credibility provides a plausible explanation to the evidence of forecasting error predictability based on forecasting disagreement found in the SPF data. Thus, accounting for imperfect credibility is important to model the formation of expectations in the economy and to understand the transmission mechanism of forward guidance announcements.

Interest Rate Policy and Exchange Rates Volatility Lessons from Indonesia

Abstract Whether or not inflation targeting adoption leads to increased volatility of exchange rates is controversial. The volatility increases with inflation targeting as a result of the flexible exchange rate regime. Others argue that inflation targeting delivers the best outcomes in terms of lower exchange rate volatility. The purpose of this paper is to investigate whether interest rate policy in inflation targeting frameworks – that is subjected to control inflation rate – may reduce the volatility of exchange rates. To test the hypothesis, we use monthly data in the case of Indonesia over the period 2005(7)-2016(7). Several control variables are introduced in the regressions. The result of the autoregressive distributed lag model proves the interest rate policy and foreign exchange intervention fail to reduce the exchange rates volatility. It seems inflation targeting in Indonesia puts too much emphasis on stabilizing the domestic currency thus leading to benign neglect of stabilizing its external value, ultimately resulting in increased exchange rate volatility. These findings suggest that central bank credibility plays an important role in conducting inflation targeting policy which operates primarily through a signalling effect.

Monetary regimes and labour institutions: An alternative interpretation of the downward trend in exchange-rate pass-through in peripheral countries

In recent years, several empirical studies have documented the decline in exchange-rate pass-through in peripheral countries. Conventional wisdom has interpreted this trend—verified in the last two decades—as the result of greater central bank credibility stemming from the implementation of formal inflation-targeting regimes. This paper offers an alternative interpretation, in line with the structuralist tradition, as it examines other instrumental transformations, concurrent with the establishment of inflationtargeting regimes, including ubiquitous labour market flexibilization. Empirical estimates for a set of peripheral countries for the period 1994–2016 show a marked correlation between the intensity of the exchange-rate pass-through and the weakening of labour market institutions.

Why is inflation targeting adopted?

Since the early 1990s, inflation targeting (IT) has been conducted in many countries and the number of the countries has been increasing rapidly. The outcomes of adopting IT has been discussed, however, the incentives of adopting IT is not fully examined. This study focuses on this issue empirically. The results are clearly divided into two types of countries. In developed countries, budget/GDP ratio, central bank credibility, exchange rate stability, and openness of the economy are deterministic elements of adopting IT, however interestingly, inflation itself does not play any roles of adopting IT. On the other hand, only inflation is the deterministic element of adopting IT in developing countries. Other elements, that are deterministic elements in developed countries, do not any effects on introducing IT. Moreover, countries would not like to limit the scope of policies when the economy’s openness is high.

Inside the black box: credibility and the situational power of central banks

AbstractDespite the consensus that the power of finance constraints central banks under financial globalization, the variation in their autonomy from market forces at the micro level of monetary policymaking remains underexplored. This article demonstrates that credibility endows central banks with situational power to make monetary policy decisions that involve less sacrifice of economic growth to price stability. Based on the comparative analysis of the policy decisions of central banks in two emerging economies, South Africa and Turkey, during 2013–2014, I show that this policy space stems from central banks’ capacity to successfully influence market expectations. The argument relies on public texts and over 130 interviews with central bankers in South Africa and Turkey and financiers in Johannesburg, Istanbul and London. The findings contribute to literature on central bank credibility and communication by exploring how credibility functions and creates room for central banks to maneuver through influencing contingent and performative expectations.

Presidential Antagonism and Central Bank Credibility

This paper uses an online survey experiment to study how President Trump's criticism of the Federal Reserve may affect consumers' long-run inflation expectations, confidence in the Fed, and responsiveness to information about inflation. A random subset of respondents view one of President Trump's critical tweets about the Fed, or the tweet plus a Washington Post article discussing the President as a threat to the Fed's independence. All respondents provide long-run inflation forecasts, before and after receiving information about past inflation and the Fed's inflation target. Finally, respondents rate their confidence in the President and the Fed. Respondents who view the tweet or tweet plus article have final long-run inflation forecasts that are farther from the Fed's target after exposure to information about the Fed's target and recent inflation. Exposure to the tweet plus news article has a polarizing effect on confidence, increasing the share of respondents with high confidence in either the Fed or the President.

The Monetary Policy Credibility Channel and the Amplification Effects in a Semi-Structural Model

The paper extends a standard semi-structural model to account for nonlinear and asymmetric effects of monetary policy credibility. In our setting, central bank credibility is proportional to the deviation of inflation expectations from the announced inflation target, with positive deviations being more costly compared to negative ones. A loss in policy credibility as a result of shocks leads to a more persistent, backward-looking inflation process, and is associated with lower output. We find that the extended model with credibility effects matches well the key macroeconomic data over specific past episodes for Indonesia and Philippines and consider its adaptation to integrated policy frameworks as an area for further exploration.

A Neural Network Scheme for Monetary Policy Rate Validation in Nigeria

This research work is an exploratory study that tried to examine the viability of adopting artificial neural network (ANN), an aspect of machine learning in the analysis of monetary data for the design and validation of monetary policy from both optimistic and normative approach. Methodologically, the research is motivated by the work of [33] which used the Greenbook real time data of the U.S. Federal Reserve's in the analysis of monetary policy reaction functions in forecasting performance using ANN. Following the work on the adoption of this technique, we tried to develop a framework based on machine learning for policy rate forecasting by analysing macroeconomic data with the aim of guiding and aiding monetary authority in making monetary policy decisions. From the results, the ANN perform better in predicting the monetary policy rate compared to the linear models and the univariate process. It also revealed the non-linearity in the behavior of the monetary policy rate in Nigeria during the study period. While the work does not mean to advocate that machine will replace human-being in policy rate determination in the monetary policy-making process; we believe that the development and implementation of this system would support building effective prediction system which can be validated. The result from the designed system is expected to enhance credibility, confidence and transparency of central banks in making an independent decision (s) based on objective forecasts and implied analysis in setting policy through a well-structured comparison of results.

The Effect of Central Bank Credibility on Forward Guidance in an Estimated New Keynesian Model

This paper examines the effectiveness of forward guidance in an estimated New Keynesian model with imperfect central bank credibility. We estimate credibility for the U.S. Federal Reserve with Bayesian methods exploiting survey data on interest rate expectations from the Survey of Professional Forecasters (SPF). The results provide important takeaways: (1) The estimate of Federal Reserve credibility in terms of forward guidance announcements is relatively high, which indicates muted forward guidance effectiveness relative to the fully credible case. Hence, anticipation effects are attenuated and, accordingly, output and inflation do not respond as favorably to forward guidance announcements. (2) The so-called “forward guidance puzzle” is shown to arise, at least in part, from the unrealistically large responses of macroeconomic variables to forward guidance statements in structural models that do not incorporate imperfect credibility and heterogeneous expectations. (3) Imperfect monetary authority credibility provides a plausible explanation to the evidence of forecasting error predictability based on forecasting disagreement found in the SPF data. Thus, accounting for imperfect credibility is important to model the formation of expectations in the economy and to understand the transmission mechanism of forward guidance announcements.

The Effect of Central Bank Credibility on Forward Guidance in an Estimated New Keynesian Model

This paper examines the effectiveness of guidance in an estimated New Keynesian model with imperfect central bank credibility. Forward guidance and the credibility of the central bank are uniquely modeled by utilizing a game-theoretic evolutionary framework. We estimate credibility for the U.S. Federal Reserve with Bayesian methods exploiting survey data on interest rate expectations from the Survey of Professional Forecasters (SPF). The results provide important takeaways: (1) The estimate of Federal Reserve credibility in terms of guidance announcements is relatively high, which indicates a degree of guidance effectiveness, but still one that is below the fully credible case. (2) If a central bank is perceived as less credible, anticipation effects are attenuated and, accordingly, output and inflation do not respond as favorably to guidance announcements. (3) Imperfect credibility and guidance are an important aspect to resolve the so-called forward guidance puzzle, which the literature shows arises from the unrealistically large responses of macroeconomic variables to guidance statements in structural models with perfect credibility. (4) Imperfect central bank credibility can also explain the evidence of forecasting error predictability based on forecasting disagreement found in the SPF data. Thus, accounting for imperfect credibility is important to model the formation of expectations in the economy and to understand the transmission mechanism of guidance announcements.

Achieving the Bank of Japan’s Inflation Target

The Bank of Japan has introduced various unconventional monetary policy tools since the launch of Abenomics in 2013, to achieve the price stability target of 2 percent inflation. In this paper, a forward-looking open-economy general equilibrium model with endogenously determined policy credibility and an effective lower bound is developed for forecasting and policy analysis (FPAS) for Japan. In the model’s baseline scenario, the likelihood of the Bank of Japan reaching its 2 percent inflation target over the medium term is below 40 percent, assuming the absence of other policy reactions aside from monetary policy. The likelihood of achieving the inflation target is even lower under alternative risk scenarios. A positive shock to central bank credibility increases this likelihood, and would require less accommodative macroeconomic policies.

Revisiting the Exchange Rate Pass‐Through to Inflation in Africa’s Two Largest Economies: Nigeria and South Africa

AbstractThis paper revisits the exchange rate pass‐through (ERPT) to inflation in Nigeria and South Africa by incorporating structural breaks and using time series variables, namely the consumer price index, nominal effective exchange rate, gross domestic product, and crude oil price. Based on the Maki cointegration test and a flexible estimation approach of the Autoregressive Distributed Lag (ARDL) model, our empirical evidence suggests that the long‐ and short‐run ERPT to inflation is complete for Nigeria, while for South Africa it is incomplete both in the long run and short run. This result indicates that prices are stickier in South Africa compared to Nigeria. The comparison between Nigeria and South Africa confirms the role of inflation targeting and central bank credibility on the ERPT. The results divulge further that output growth in Nigeria increases inflation in the long run while it is anti‐inflationary in the short run. For South Africa, the effect of output growth is negatively insignificant. In addition, the long‐run effect of oil price is negative and significant for Nigeria, while for South Africa the short‐run effect of oil price is positive and significant. Therefore, the findings of this paper will assist the monetary authorities to achieve monetary policy objectives.